chapter 18

Copyright © 2006 McGraw Hill Ryerson Limited 18-1

prepared by:Sujata Madan

McGill University

Fundamentals

of Corporate

Finance

Third Canadian Edition


Chapter 18 Financial Planning

What is Financial Planning

Financial Planning Models

Planners Beware

External Financing and Growth


What is Financial Planning?The Financial Planning Process

Analyzing the investment and financing choices open to a firm.

Projecting the future consequences of current decisions.

Deciding which alternatives to undertake.

Measuring subsequent performance against the goals set forth in the financial plan.


What is Financial Planning?

The Financial Planning Process Planning horizon: Time horizon for a financial

plan.

Departments are often asked to submit 3 alternatives Optimistic case = best case Expected case = normal growth Pessimistic case = retrenchment


What is Financial Planning?The Financial Planning Process

Financial plans help managers ensure that their financing strategies are consistent with their capital budgets.

They highlight the financing decisions necessary to support the firm’s production and investment goals.


What is Financial Planning?Why Build Financial Plans?

1. Contingency Planning2. Considering Options3. Forcing Consistency


Financial Planning Models An Example of a Financial Planning Model

Pls insert Fig 18.1 here

Pls insert Fig 18.1 here


Financial Planning Models An Example of a Financial Planning Model

Pro Formas: Projected or forecasted financial statements.

Percentage of Sales Models: Planning models in which sales forecasts are the driving variable and most other variables are proportional to sales.

A balancing item (or plug): Variable which adjusts to maintain the consistency of a financial plan.


Financial Planning Models Executive Cheese Financial Model

Executive Cheese’s simplified year end financial statements are below:

Income StatementSales $1,200Less: Costs 1,000Net Income $200

Balance SheetAssets $2,000 Debt $800

Equity 1,200Total $2,000 Total $2,000


Financial Planning ModelsExecutive Cheese Financial Model

Percentage of sales model used to build pro forma financial statements for next year.

Assumptions: Sales will increase by 10% next year. Costs will be a fixed proportion of sales, so they

too will increase by 10%. The firm has no spare capacity and must increase

assets by 10%. The firm will keep its current debt-equity ratio.



Executive Cheese’s simplified pro formas are below:


Balance SheetAssets $2,200 Debt ?

Equity ?Total $2,200 Total ?

$880

1,320

$2,200



Notice that the dividend payment is not chosen by management.

Instead, it is a consequence of the other decisions.

Most firms would not want dividends to be a consequence of other decisions.

The managers prefer to show a steady progression of dividends.



Assume, now, that instead of accepting a dividend which falls out of the planning process, that management commits to a $180 dividend.



Pro forma Balance Sheet with dividends fixed at $180 and debt used as the balance item.


Balance SheetAssets $2,200 Debt ?

Equity ?Total $2,200 Total ?

$960

$2,200

1,240


Financial Planning Models Executive Fruit – 2002 Financial Statements


Financial Planning Models Executive Fruit – 2003 Pro Forma Financial Statements


Planners Beware

Pitfalls in Model Design Many models ignore realities such as

depreciation, taxes, etc. Percent of sales methods are not realistic

because fixed costs exist. Most models generate accounting numbers not

financial cash flows Adjustments must be made to consider these

and other factors.


= (Net assets/Sales) x Increase in Sales - Addition to Retained Earnings

External Financing and Growth Required External Financing

= (Growth Rate x Initial Assets)- Addition to Retained Earnings


= Addition to Retained Earnings / Assets

= Plowback Ratio x ROE x (Equity / Assets)

External Financing and Growth Internal and Sustainable Growth

Internal Growth Rate

Sustainable Growth Rate = Plowback Ratio x ROE


Summary of Chapter 18

The tangible product of the financial planning process is pro forma financial statements, the establishment of financial goals and the creation of a benchmark for evaluating subsequent performance.

A good financial planning process forces the financial managers to think about the future and to devise strategies for the events which might occur.


Summary of Chapter 18 Focus on aggregate decisions such as whether to

commit to capital investment, debt policy and the target dividend payout ratio.

One output of a financial model is an understanding of effects of growth on the need for external financing.

The internal growth rate is the maximum rate that the firm can grow at if it relies entirely on invested profits to finance its growth.

The sustainable growth rate is the rate at which the firm can grow without changing its leverage ratio.

chapter 18

Documents

financial managers

financial planning model

contingency planning

percentage of sales

growth internal

sales addition

income statement sales

external financing